Debt Relief?

Paying off your mortgage early might be the wrong choice for many homeowners

September 26, 2006|By The Morning Call

The old question about whether you should spend extra money on paying off the mortgage early has a new twist.

In a recent research report, economists for the first time posed a very specific and very common question: "If I have extra money for savings, should it go toward retirement or paying down my mortgage?" Though the report is riddled with dense jargon and algebraic formulas, the conclusion is crystal clear.

"About 38 percent of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice," said the report by economists Gene Amromin of the Federal Reserve Bank of Chicago, Jennifer Huang of the University of Texas at Austin and Clemens Sialm of the University of Michigan.

And as a practical matter, that percentage is much higher, considering the ultraconservative assumptions the economists made. So easily half of all Americans facing this decision could be making the technically wrong choice.

Just because it's not mathematically rational doesn't make it a bad choice. Some people clearly derive a non-financial benefit from being debt-free, which is why they make a priority of paying off the mortgage early. But you should realize what that debt-aversion is costing you, and consciously decide it's worth it.

"Instead of trying to maximize their wealth, people pay more attention to getting rid of their debt," Amromin said. "They are not a dispassionate comparer of dollars and cents. Somehow a dollar you owe is worth more than a dollar in your pocket."

The study found that U.S. households making the "wrong" choice by paying off the mortgage early cost themselves a collective $1.5 billion per year, forgoing a yield of 11 cents to 17 cents for each dollar misallocated.

"The average household leaves about $300 on the table by not doing the right thing," Amromin said.

Consumers making the "right" choice to prepay their mortgage were largely those who didn't itemize tax deductions and those who already maxed out their retirement contributions, Amromin said.

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For more info

To download a copy of "The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings," go to www.nber.org/papers and search for working paper 12502.